Effective Interest Method

PFRS 9 requires that discount on bonds

payable, premium on bonds payable and bond
issue cost shall be amortized using the effective
interest method.

The effective interest method is also

known as “scientific method” or simply “interest
method”.
 2 KINDS OF INTEREST RATE

Nominal • Coupon Rate

Rate • Stated Rate

Effective • Yield Rate

Rate • Market Rate
The effective rate is the rate that exactly
discounts estimated future cash payments
through the expected life of the bonds payable
or when appropriate, a shorter period to the net
carrying amount of the bonds payable.
 When bonds are sold at face value, the
effective rate and the nominal rate are the
same.

 When bonds are sold at a discount, the

effective rate is higher than the nominal rate.
(END)

 When bonds are sold at a premium, the

effective rate is lower than the nominal rate.
(NEP)
Effective Interest Method
• Under the effective interest method, the effective interest
expense is determined by multiplying the effective rate by the
carrying amount of the bonds.

• The carrying amount of the bonds changes every year as the

amount of premium or discount is amortized periodically.

• The effective interest is then compared with the nominal

interest.

• The difference is the premium or discount amortization.

The premium amortization is computed as follows:

Nominal interest (nominal rate x face value) xx

Less: Effective Interest (effective rate x carrying amount) xx
Premium amortization xx
The discount amortization is computed as follows:

Effective Interest xx
Less: Nominal Interest xx
Discount Amortization xx
On January 1, 2012, an entity issued two-year 8%
P1,000,000 face value bonds for P964,540, a price which
will yield a 10% effective interest cost per year. Interest
is payable semi-annually on June 30 and December 31.
Date Interest Interest Discount Carrying
Paid Expense Amortization Amount

Jan. 1, 2012 964,540

Jun. 30, 2012 40,000 48,227 8,227 972,767
Dec. 31, 2012 40,000 48,638 8,638 981,405
Jun. 20, 2013 40,000 49,070 9,070 990,475
Dec. 31, 2013 40,000 49,525 9,525 1,000,000

Jan.
Dec.130
June 31Cash
Interest
InterestExpense
Expense 964,540
48,638
48,227
Discount
Cashon bonds payable
Cash 35,460 40,000
40,000
Discount
Bonds Payable
on bonds
Discount payable
on Bonds Payable 1,000,000
8,638
8,227
 On January 1, 2012, an entity issued three-year 12%,
P1,000,000 face value bonds for P1,049,740, a price
which will yield a 10% effective interest cost per year.
The interest is payable annually every December 31.
Date Interest Interest Premium Carrying
Paid Expense Amortization Amount

Jan. 1, 2012 1,049,740

Dec. 31, 2012 120,000 104,974 15,026 1,034,714
Dec. 31, 2013 120,000 103,471 16,529 1,018,185
Dec. 31, 2014 120,000 101,815 18,185 1,000,000

Jan. 131Cash
Dec. Interest Expense 1,049,740
104,974
Premium
Bonds Payable
on Bonds Payable 1,000,000
15,026
Premium Cash
on Bonds Payable 49,740
120,000
On July 1, 2012, Snow Pink Company issued
4,000 of its 8%, P1,000 face value bonds payable
for P3,504,000. The bonds were issued to yield
10%. The bonds are dated July 1, 2012 and
mature on July 1, 2022. Interest is payable semi-
annually on January 1 and July 1. Using the
effective interest method, what amount f the
bond discount should be amortized for the six
months ended December 31, 2012?
 Solution:
Interest Expense (3,504,000 x 10% x 6/12) 175,200

Interest Paid (4,000,000 x 8% x 6/12) 160,000

Discount Amortization for six months 15,200

On January 1, 2012, West Company issued 9%
bonds in the face amount of P5,000,000, which
mature on January 1, 2022. The bonds were
issued for P4,695,000 to yield 10%. Interest is
payable annually on December 31. West uses
the interest method of amortizing bond
discount. In the December 31, 2012 statement
of financial position, what is the carrying
amount of the bonds payable?
 Answer: 4,714,500
Interest expense (4,695,000 x 10%) 469,500
Interest paid (5,000,000 x 9%) 450,000
Amortization of discount for 2012 19,500

Carrying Amount, 1/1/2012 4,695,000

Discount Amortization 19,500
Carrying Amount, 1/12/2012 4,714,500
Market Price or Issue Price of Bond Payable
 The market price or issue price of bond
payable is equal to the present value of the
principal bond liability plus the present value
of future interest payments using the
effective or market rate of interest.
Market Price or Issue Price of Bond Payable
 The present value of the principal bond liability is
equal to the face value of the bond multiplied by the
present value of 1 factor at the effective rate for a
number of interest periods.

 The present value of the future interest payments is

equal to the periodic nominal interest multiplied by
the present value of an ordinary annuity of 1 factor
at the effective rate for a number of interest
periods.
 Illustration 1
Face Value 4,000,000
Nominal rate 6%
Effective rate 8%

The bonds are issued on January 1, 2012 and mature in four years on
January 1, 2016. The interest is payable annually every December 31.

Since the interest is payable annually, there are 4 interest periods. The
relevant present value factors are:

PV of 1 at 8% for 4 periods .7350

PV of an ordinary annuity of 1 at 8% for 4 periods 3.3121
The Present Value of the bonds is computed as follows:

Present Value of principal (4,000,000x.7350) 2,940,000

Present Value of annual interest payments
(240,000x3.3121) 794,904
Total Present Value 3,734,904
Date Interest Interest Discount Carrying
Paid Expense Amortization Amount

Jan. 1, 2012 3,734,904

Dec. 31, 2012 240,000 298,792 58,792 3,793,696
Dec. 31, 2013 240,000 303,496 63,496 3,857,192
Dec. 31, 2014 240,000 308,575 68,575 3,925,767
Dec. 31, 2015 240,000 314,233 74,233 4,000,000
 Illustration 2 – Serial Bonds
Face Value of Bonds 3,000,000
Nominal Rate 12%
Effective Rate 10%
Date of Issue January 1, 2012

The Bonds Mature on every December 31 of each year at the rate

of P1,000,000 for 3 years. The interest is payable annually on
December 31. The present value of 1 at 10% is as follows:
One Period 0.9091
Two Periods 0.8264
Three Periods 0.7513

What is the Market Price or Issue Price of the Bond as of 1/1/2012?

 Date Principal Interest Total PV Factor Present
Payment Payment Payment Value
12/31/2012 1,000,000 360,000 1,360,000 .9091 1,236,376
12/31/2013 1,000,000 240,000 1,240,000 .8264 1,024,736
12/31/2014 1,000,000 120,000 1,120,000 .7513 841,456
Total Present Value 3,102,568

Date Interest Interest Premium Principal Carrying

Paid Expense Amortization Payment Amount
Jan. 1, 2012 3,102,568

Dec. 31, 2012 360,000 310,257 59,743 1,000,000 2,052,825

Dec. 31, 2013 240,000 205,282 34,718 1,000,000 1,018,107

Dec. 31, 120,000 101,893 18,107 1,000,000 -

2014
1. Issuance of Bonds
Cash 3,102,568
Bonds Payable 3,000,000
Premium on Bonds Payable 102,568

2. Payment of Interest
Interest expense 360,000
Cash 360,000

3. Amortization of Premium
Premium on Bonds Payable 59,743
Interest expense 59,743

4. Payment of Principal
Bonds Payable 1,000,000
Cash 1,000,000
White Company issued P2,000,000 face value of
10-year bonds on January 1. The bonds pay
interest on January 1 and July 1 and have a
stated rate of 10%. If the market rate of interest
is 8%, what will be the price of the bonds?
 Answer: 2,279,000
PV of 1 at 4% for 20 periods .46
PV of ordinary annuity of 1 at 4% for 20 periods 13.59

PV of Principal (2,000,000x.46) 920,000

PV of Interest Payments (100,000x13.59) 1,359,000
Issue Price of Bonds 2,279,000
Effective Interest Method – bond issue cost

 PFRS 9 provides that “transaction costs” that are

directly attributable to the issue of a financial liability
shall be included in the initial measurement of the
financial liability.

 Transaction costs are defined as fees and

commissions paid to agents, advisers, brokers and
dealers, leaves by regulatory agencies and securities
exchange, and transfer taxes and duties. Clearly,
transaction costs include bond issue costs.
Effective Interest Method – bond issue cost
 The calculation of effective interest rate shall include all
transaction costs, premiums and discounts.

 Thus, bond issue costs will increase discounts on bonds

payable and will decrease premium on bonds payable.

 Under the effective interest method, bond issue cost

must be “lumped” with the discount on bonds payable
and “netted” against the premium on bonds payable.
On January 1, 2012, Taguig Company issued a 3-year bonds
with face value of P5,000,000 at 99. The nominal rate is 10%
and the interest is payable annually on December 31.
Additionally, Taguig Company paid bond issue cost of
P150,000.

The PV of 1 at 11% for 3 periods is .7312 and the PV of an

ordinary annuity of 1 for 3 periods is 2.4437.

The PV of 1 at 12% for 3 periods is .7118 and the PV of an

ordinary annuity of 1 for 3 periods is 2.4018.

What is the interest expense for 2011 using the effective

interest method?
 Answer: 559,680

x – 11%
12% - 11%
11% = 4,877,850
X = 4,800,000
4,800,000-4,877,850
12% = 4,759,900
4,759,900-4,877,850

77,850
117,950 = .66

4,800,000 x 11.66% = 559,680